What the New Cost-Basis Legislation Means for You

Question: I've heard that my broker is going to have to start tracking my cost basis and reporting the information to the Internal Revenue Service. Does that mean I can get rid of my cost-basis spreadsheets?

Answer: The topic of cost basis tends to elicit headaches or blank stares from most investors. But cost basis isn't all that complicated. Put simply, your cost basis in your investments is the purchase price, adjusted for dividend and capital gains distributions as well as stock splits, commissions, and other fees. Cost basis has important tax implications. That's because the difference between your cost basis and the current selling price of your security determines your profit or loss as well as how much you owe the government in taxes (or how much you can claim in deductions for capital losses).

Here's a simple example. Say you take advantage of your brokerage firm's commission-free trading and buy shares of a non-dividend-paying stock for $12 per share; you sell two years later when the stock is at $25. Assuming this trading was going on in your taxable account, you'll owe taxes on the capital gains of $13 a share, but you won't owe taxes on your original $12--your cost basis. Of course, cost basis isn't always so straightforward, especially given that many people purchase the same security at multiple intervals via dollar-cost-averaging. In such instances, people can calculate cost basis in more than one way. For example, they can cherry-pick specific lots, specifying that their broker sells their high-cost-basis securities first. Employing such a strategy can help reduce their tax bills.

What's Changing?
In the past, investors were charged with tracking their own cost basis in their holdings, and that, in turn, dictated how much they owed in taxes when they bought and sold assets. But according to a 2001 tax gap study performed by the IRS, investors were reporting less than they owed--to the tune of at least $11 billion dollars in unreported capital gains by individual taxpayers. The study found that inaccurate reporting of securities' gains or losses from sales was primarily the result of taxpayers' inaccurate reporting of cost basis. Since then, IRS, Congress, and the financial-services industry have sought to improve both accountability and accuracy in cost-basis calculations.

To help collect that lost revenue, the 2008 Emergency Economic Stabilization Act included a provision that requires financial intermediaries, such as brokers, banks, custodians, transfer agents, and mutual fund companies, to report adjusted cost basis for taxable accounts to both the IRS and taxpayers. Financial institutions must also indicate whether the gain or loss is short- or long-term and must flag losses that aren't permitted under the wash-sale rules. (Wash sales occur when an investor sells a security at a loss but buys a "substantially identical security" within 30 days of the sale of the first security. Under the wash-sale rule, the loss would be disallowed for tax purposes.)

The new cost-basis rules will apply for stock purchases made on or after Jan. 1, 2011. Investment providers will need to track and report cost basis for mutual fund shares bought and dividend-reinvestment plans made on or after Jan. 1, 2012. Similar reporting requirements will go into effect for bonds, options, and other securities purchased on or after Jan. 1, 2013.

Exchange-traded funds present a special case because not all brokerage firms interpret ETFs and the cost-basis rules the same way. For ETFs structured as unit investment trusts, the rules will kick off this year. But most ETFs won't be subject to the new rules until 2012. Check with your broker to learn more about the specific guidelines and deadlines for calculating the cost basis for ETFs.

What It Means for You
But just because financial intermediaries are now required to keep tabs on your cost-basis calculations doesn't mean that you can tune out the topic.

For starters, the new cost-basis legislation does not cover stocks purchased prior to 2011, mutual funds purchased before 2012, and bonds purchased before 2013. So if you own securities that you purchased before those years, you're still on the hook for maintaining cost-basis records. (Don't panic: Many fund companies and brokerage firms have been maintaining these records for their clients all along.)

For more information on the basics of understanding and calculating cost basis, this article provides some details. Fidelity also offers some helpful information on its website.

In addition, just because your financial institution is sending your cost-basis information to the IRS, you'll still have to fill out Schedule D when you file your tax return, detailing your gains and losses for the previous year.

Moreover, the onus is on investors to let their financial institutions know, in advance of the trade settlement date, what method of calculating cost basis they'd like to use. Most brokerage firms employ a single default method--usually the first-in, first-out method--and apply it to all accounts unless clients specifically indicate before the settlement date that they want their broker or advisor to use a different method to calculate cost basis. Using the FIFO method means that if you sell some shares of a security that has gone up steadily in value since you originally purchased it, you'll owe more taxes than if you averaged your share prices or used the specific-share-identification method and sold your higher-cost shares before your lower-priced ones. Thus, the default method isn't the best option for everyone, and you don't want to end up overpaying for taxes because you didn't specify that you wanted your broker to use a different method before the settlement date.

But the rules and regulations regarding changing the cost-basis calculation method for accounts and/or specific trades will vary across brokerage firms.  Wells Fargo (WFC), for example, offers nine different ways to calculate cost basis. So contact your broker for more information on how much flexibility it offers in cost-basis calculations. Also confer with your financial advisor or tax advisor to help determine the right method of calculating your own cost basis.

Additionally, while it was previously up to individual investors to report wash sales, the brokerage firm is now obligated to report wash sales to the IRS, provided that both the sale and repurchase of an identical security (defined as those with the same CUSIP) were done in the same account. Given that many investors hold multiple taxable accounts, it's important for investors and their tax advisors to actively monitor wash sales across all investment accounts and comply with IRS requirements to compute wash sales.